Monday, April 16, 2012

In this post I want to highlight an interesting discussion I had over at MNE with other commenters about banks and their ability to print money for their acquisitions. An anonymous commented said:

Bank credit money is also created when banks make asset purchases or payments on their own account, not only when they make loans." to which Matt Franko added "imo they must be able to buy the property and construction of their branches by crediting bank accounts of the landowners and contractors.

I was at first resistant to Matt's assertion that banks can print every time they want to make an acquisition. But thinking it through, that's almost about right, but I wanted to add a clarification, based on my own understanding, that not all payments banks make, though they’re paid as credits to accounts, are new money. That credit will result in a debit, and sometimes the debit is to their equity. For example, if they buy their office supplies, pay their workers, or settle their utility bills, it does not add new money to the economy. If the bank uses its earnings (part of its equity) which is money received from elsewhere, it is not money created at the point of credit. Anonymous commenter says:

Whenever they spend or lend they do so with their own privately created credit. They only use reserves to settle with each other or with the central bank and treasury (or when they borrow/lend reserves from/to each other,)or cash when people withdraw it. Everything else is done with the 'inside money' they create themselves. ..

When a bank purchases something or pays someone they credit an account, as they do when they make a loan. The credit is typed into existence through a computer keyboard. This adds to the bank's overall liabilities. Banks have to maintain a *ratio* of capital and or reserves. That ratio has to "come from somewhere" in the case of said purchases/payments, but it's only a fraction of the overall credit/deposit money credited by the bank. If the created deposit is then transferred to another bank then of course settlement takes place with reserves, as always.

Not much I really disagree with. I just would add that loans and branch locations are two different animals. When a bank buys a branch property, it has to be funded by a corresponding liability - its own equity, a loan from somewhere else, or via deposits.But when a bank buys a loan, it expects a positive income from the spread between the loan and the cost of the liability that results from it. Then when a bank buys property for a branch, or a computer printer, there's usually no income assumption, as they’re an expense outlay for the bank. While it is true that purchases or payments are created as an accounting entry by the bank, if they result in net equity outflow, that outflow cannot be compensated by the bank by printing reserves into existence.One has to distinguish whether that payment is for an expense or for funding a loan. Anything that is considered an expense outlay is not new money created by the bank. And any net cost that results from that purchase is not funded with new money, as is the case with equity capital that has to be raised to maintain the ratio. That’s why, as Tom Hickey said, "the bulk of horizontal money creation comes from credit extension, not asset purchases or payments on their own account". Tom also mentions in the discussion.

When a bank creates bank money to purchase assets other than loans or fund expenses, it is in effect borrowing at the price of reserves, since it is creating deposits that have to clear (after netting). Even if a bak uses its own excess reserves, that's interest it is losing on lending in the interbank market. Banks can create money but not "for nothing." But it is true that banks borrow at a much lower rate than non-banks in the sense that they don't have the spread to deal with.

This is also why, I believe, a bank that has no earnings or no equity cannot continue spending just because it can create money out of thin air by crediting an account. If the spending is going to be funded by liabilities, then the bank incurs greater liquidity and insolvency risk. As Dan Kervick also adds:

But the money they create to buy stuff for themselves is just as much a liability as money they create in the process of making a loan. They create an account for the seller of the goods and credit that account. If the seller of the goods then writes a check on that account to someone whose account is at another bank, the first bank will have to make a payment to that other bank that is settled and cleared through the banks' reserve accounts at the central bank. And if the seller comes into the bank and decides to withdraw the total amount in the account, the bank will have to hand him a bunch of vault cash. Clonal also adds:

I believe the fact that revenue is recognized immediately on making the loan is where all the problems are coming from. More money than the amount of the loan is created at the time of the inception of the loan. The excess money is then capitalized after accounting for things like provisions for loan losses etc.

To which I acknowledge, I could be referring to an outmoded banking model. As far as I know, if a bank keeps the loan in its books, revenue is recognized as and when it receives interest income, not when the loan is made. Of course, if a bank securitizes everything or most of the loans it makes, revenue will be recognized when the loan is sold, even if it's at the point the loan is made.

P.S. I add in comment discussion that Basel rules further limit this printing.

10 comments:

"Then when a bank buys property for a branch, or a computer printer, there's usually no income assumption, as they’re an expense outlay for the bank."

A friend of mine worked for a small comm bank in Key West some years ago and they had one of the only ATMs right in the combat zone there for some years while she was there, she said they took in $350,000 per year just off their ATM. (pretty sweet)

And then of course anyone needs a place to do business. So they get a branch and put a loan officer in there and have a conference room, etc... and start to do Equity Loans, mortgages, etc... we all need a 'storefront' to do business and they have a tremendous advantage over non-banks in sucking up all of the prime locations as like you say they only have to offset the purchase price with like 8% equity (or less) and the rest at deposit rates which now are near zero.

And this is just for bank branch operations. In my area some are getting involved directly in property via wholly owned Real Estate Divisions of the banks...

Another thing you see is a commercial strip with like say 6 storefronts and one will be the bank branch, the other 5 are a Nail Salon, subway, used to be video rental now vacant, pizza joint, dunkins', maybe post office. Perhaps some even have offices on a second floor (medical, etc...)

I bet that since the "branch" is under the same roof (loophole), they can build out and operate this 6+ storefront project by crediting bank accounts of the contractors just like it was a stand-alone branch.... no way a non-bank developer can compete with them as you have to put 20% down and pay loan interest on the other 80% if you can get financed at all.

Just drive around and you will probably notice the same type of set up...

In your area, is it common for the bank to own the commercial area and be the landlord? How prevalent is it? Because in that case, then yes, owning property will be considered income generating for the bank. It would likely result in higher property bubbles if banks are given unlimited leeway to bid for these commercial properties.

Yes, this should not be allowed. I thought Basel rules disallowed it, in that property assets are given 100% risk weight, meaning all property purchases should be funded wholly with bank equity capital. I guess the US hasn't been following Basel rules if they're doing this on a major scale there.

Quote:“For several years now, the Fed has been making money available to the financial sector at near-zero interest rates. Big banks and hedge funds, among others, have taken this cheap money and invested it in securities with high yields. This type of profit-making, called the “carry trade,” has been enormously profitable for them.”

Warren comments thatQuote:You’d think the former chief bank regulator would know the banks they regulate and supervise aren’t allowed to do this, and that it’s up to the FDIC to see they don’t

The repeal of Glass Steagal in the USA allowed banks to get into businesses, including betting against their own clients - which would previously have been illegal, and is always unethical.

Well there you go. What's illegal elsewhere is legal in the US. Although many countries don't also divide between commercial and investment banking activities.

However, and it's been almost a decade since I last looked at some Basel rules, if it's a bank affiliate that invests in investment banking or in real estate properties, all their capital will need to be bank capital. Basel rules limit what banks can lend to affiliates as a percentage of their total portfolio, and any loan amount above that percentage gets deducted from the bank's calculation of its capital. No way around using crediting ability to make unlimited purchases. Maybe different in the US?

"…This is also why, I believe, a bank that has no earnings or no equity cannot continue spending just because it can create money out of thin air by crediting an account…"

Of course it can't. That's not a constraint though.

If a bank can't generate earnings from printing money out of thin air it doesn't deserve to succeed and should be shut down or bought out.

What banks do is like shooting fish in a barrel. Further, if they don't compete well they get bought out by more successful banks and the pricipals walk away with a pile of money for being incompetent.

"a bank that has no earnings or no equity cannot continue spending just because it can create money out of thin air by crediting an account"

I think this 'constraint', as Paul says, is probably much more flexible and fluid for a bank than it would be for anyone else. Technically insolvent banks often seem to be able to keep operating as normal, as if nothing is wrong.

This aside, I agree with the point that even if a bank is 'creating money' to pay for real goods and services, ultimately that money has to 'come from somewhere', so it's different to the purchase of a financial asset in the form of a loan.

However, loans are not the only financial assets out there, so I'm thinking that when banks purchase ANY kind of financial asset they can essentially do so with 'money they create themselves'.

Real assets are more complicated perhaps, although if the asset is a rental property, for example, then maybe it's not so different overall?

Paul, very harsh feeling against the banks. But if you're American, Irish, or Icelandic, I can't blame you.

Anonymous, yes, it would appear that banks have greater leeway to keep crediting, even when insolvent, vs. regular folks and companies. The system relies a lot on the regulator, and particularly bank examiners, to keep it honest. There's enough regulation out there to keep things honest, as long as they're being followed.

but what can you expect from banks who do this,this,this,or whatever else we still don't know about.

As I said in our MNE discussion, banks are not in the business of owning property. They are in the business of extending loans, and they want to get paid back the loans and earn the interest rather than owning the property. Capital tied up in property is capital they cannot use to churn new loans, and any properties they end up with because of soured loans are immediately disposed of. These are all hits to bank capital.

Basel, not oddly, is silent on real estate investments as rental properties because these have ever been considered appropriate bank assets. Mortgages backed by rental properties, yes, but not the property itself. That opens the bank to landlord risk, which I'm sure no regulator or bank risk manager knows how to manage.

Search This Blog

"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.